Breaking up the Big Banks: Great Idea, Stupid Idea or Something In-between?

The idea of "too big to fail" is that certain corporations, especially banks, are so large and interconnected that the government would have to bail them out in the event of failure to avoid catastrophic ripple effects throughout the economy. Thus during the 2007-2009 financial crisis, the Federal Reserve’s committed over $600 billion in taxpayers’ money to the six biggest U.S. banks through purchases of distressed assets and low-interest loans.
Increased government oversight and new regulations are supposed to reduce risk of massive bank failure and thus obviate the need for future bailouts. However, the US financial system remains highly concentrated: by the end of 2014, the five largest U.S. banks held assets of $6.7 trillion dollars, 39 percent of that year’s GDP value of $17.3 trillion. The risks that $6.7 trillion in assets pose to our 17 trillion dollar plus economy are massive. A loss of “just” $1 trillion would have been six percent of the 2014 GDP.

Some contend that regulating big banks will never be enough, however, because regulations alone cannot eliminate the risk of bank failure, and the failure of these huge financial institutions would still wreak havoc throughout the economy without government intervention. If we really want to eliminate the need to rescue banks in time of crisis, banks will have to be smaller so that their financial fortunes are less consequential to the larger economy (or so the argument goes).

Those in favor of breaking up the biggest banks also note that a purely regulatory approach ignores the prevalence of “regulatory capture” in the banking industry, as regulators tend to identify with the institutions they are supposed to regulate, especially when these high-paying institutions are considered potential future employers. Rules that seem to have teeth when enacted may end up pretty toothless in practice. If the big banks can’t be properly regulated, there will be another financial crisis – and, most likely, another bailout. Some argue that the only solution is to limit the damage by limiting how big banks can get.

Michael Grunwald disagrees. He argues that breaking up the biggest banks may sound great in theory but is much less so in reality. Grundwald points out that the debate over size has been one-sided, ignoring the benefits of bigness (e.g., economies of scale, ability to finance very large corporate undertakings, like mergers and acquisitions), the potential costs of breakups (e.g., lower productivity, higher transaction costs), and what’s already been done to address the too-big-to-fail problem (something called Dodd-Frank).

Plus, the U.S. banking system is actually smaller as a percentage of the economy and much less concentrated at the top than is the case in many developed countries. Breaking up the big banks would make US banks less competitive in the global marketplace for financial services.As Grundwald puts it, “If Uncle Sam breaks up the US mega-banks, their largest clients would just move their business to huge foreign banks that could still provide one-stop shopping for a variety of global services.” The resulting pain wouldn’t just be felt by overpaid financiers – it would be felt throughout the US economy.